2023-12-21 10:04:50 ET
Summary
- Warner Bros. Discovery has recently engaged in talks of potentially acquiring Paramount Global.
- The potential deal could put Warner Bros. Discovery back at square one and reverse any improvements it's recently made to improving cash flows.
- Although talks are in the preliminary phase, the development impacts investors' confidence in management's ability in righting Warner Bros. Discovery's ship amid rapid declines in linear TV that are outpacing DTC margin expansion.
In our most recent coverage of the Warner Bros. Discovery, Inc. ( WBD ) stock, we had discussed why the company is not yet out of the woods on its post-merger restructuring efforts. Specifically, we had highlighted recent improvements in the direct-to-consumer ("DTC") business and said contributions to a sustained pace of cash flow growth as positives. However, execution risks remain, given the rapid decline in WBD's linear networks business - its main source of profit and cash flows. Balancing DTC growth at scale towards self-sufficiency, alongside accelerating secular declines in the traditional linear business and inherent unpredictability in the studios business remains a delicate art. And WBD has yet to show durability in emerging from the situation on the right side of the ship.
Meanwhile, recent talks on a potential merger with industry rival Paramount Global ( PARA , PARAA ) are likely to exacerbate the situation in our opinion. Said news gives us reason to drive our guards up again and reduce confidence in management's ability in righting WBD's ship. The company has only just made slight tangible improvements to its deleveraging and margin expansion efforts. Yet management is already considering another high-profile merger - and this time, with a candidate that faces similar trials it had been trying to, but has not yet, overcome during the past 20 months since the spinoff.
As previously discussed , we believe much of the WBD stock's turmoil since the merger has stemmed from its negative return on invested capital. The company is also facing increased incremental pressure from rising capital costs. The rapid secular decline in linear TV is outpacing the pace of DTC margin expansion, which effectively limits WBD's self-sufficiency in funding longer-term growth. With the company already walking a tightrope, we believe the potential pursuit of another merger - particularly another media juggernaut with extensive exposure to the declining linear business - is likely to result in a repeat of the turmoil faced in the past two years, and net out any ensuing synergies.
An Overview of the Potential WBD-Paramount Merger
Reports have surfaced that WBD CEO David Zaslav has been in talks with Bob Bakish from Paramount earlier this week on a potential merger of the two companies. While discussions remain preliminary and details are limited on the potential deal's structure, the idea of WBD being open to a capital-intensive merger given where its business stands at the moment is abhorrent in our opinion.
Paramount is already struggling to improve its respective DTC segment's economics while managing weakness in its core linear operations. It also faces its own profile of elevated execution risks, with management's near-term financial goals not yet sufficiently de-risked for rapidly evolving dynamics within the industry in our opinion. This is corroborated by Paramount's growing interest in pursuing a strategic sale of the entirety or a portion of its business in recent months to bolster cash flows. The company has already engaged in a string of divestments in non-core assets, including the recent sale of its Simon & Schuster book publishing subsidiary to KKR. It has also restructured terms within the compensation plans for senior executives to account for a potential change of control.
Similarly, WBD has been prioritizing the strengthening of its balance sheet amid the capital-intensive transition to DTC streaming and accelerating secular declines in its core linear business. But, instead of pursuing a sale, the company has largely been strategic in restructuring its internal operations to unlock value for shareholders. The priority has even been embedded in the adjusted pay plans for Zaslav and its cohort of colleagues within the senior management team. Their bonuses now depend primarily on WBD's cash flow growth and debt reduction, eradicating the "growth at all costs" narrative that had previously taken precedence in business plans. Every act so far has been done in the name of freeing up liquidity and expanding profit margins to support its ongoing deleveraging efforts. Despite initially putting investors on edge, Zaslav's aggressive cost-cutting calls have started to show through WBD's consistent cash flow growth in recent quarters.
As a result, we believe the company's recent consideration of M&A activity amid ongoing restructuring efforts is a cause for concern. Not only are said considerations premature given WBD's current capital structure, but they would also increase the company's linear TV exposure and potentially derail ongoing improvements observed in its transition to DTC.
Negative ROIC
Diving a little deeper into the fundamentals, both companies currently generate a negative return on capital investments. Specifically, WBD's ROIC structure fell into the negatives after its spinoff in April 2022. The combination of significant leverage on its balance sheet, growing losses in its DTC business, and diminishing profits in its linear segment were key culprits. And aggressive restructuring efforts implemented shortly post-spinoff had only pressured the metric further. This included substantial severance costs stemming from headcount reductions post-spinoff, as well as significant write-offs resulting from the cancellation of several high-profile projects. The company has also made significant investments into the back-end technology needed to combine the HBO Max and Discovery+ content libraries, in addition to launch costs pertaining to the Max rebrand.
It was not only until recent months when WBD showed positive progress, with consistent delivery of cash flow growth supportive of its longer-term growth trajectory and deleveraging goals. WBD's DTC segment has also recently achieved EBITDA breakeven for the first time. However, it is too soon to determine if this achievement is sustainable, given adverse churn dynamics in WBD's overlapping streaming platforms. The DTC advertising business' inherent sensitivity to near-term macroeconomic uncertainties also poses as a risk to EBITDA expansion. As such, the company has yet to show substantial progress in sustainably overcoming the irreversible declines in linear TV. Despite recent progress, WBD's ROIC remains in the negatives at a level similar to where it was immediately post-spinoff.
While WBD has been gradually making improvements to its ROIC, Paramount has been moving in reverse and diving deeper into the negatives. A company's underlying ROIC is a critical factor to its stock performance, as valuations are essentially a function of the costs-returns spread on capital investments. Thus the hypothetical merger with Paramount would likely trounce the recent improvements pulled off by WBD and take it back to square one.
The potential merger also comes at a time of elevated capital costs. The earliest WBD could engage in M&A activity would be in the second quarter of 2024, given the two-year restriction levied by tax benefits incurred during the April 2022 spinoff.
Although recent signs of easing inflationary pressures are fueling bets on rate cuts heading into 2024, underlying risks remain that would keep the " higher for longer " narrative intact - or worse, bring incremental rate hikes back onto the table. Specifically, core price increases have been stubborn despite easing headline CPI. The rebound in shelter costs, exacerbated by a resilient housing market, alongside fluctuations in energy dynamics are complicating the work of tightening financial conditions in taming inflation.
An elevated capital cost environment would likely exacerbate WBD's ROIC structure in the event of a business combination with Paramount, and further limit its valuation prospects. Specifically, Paramount itself is a highly leveraged business, with a net debt to LTM OIBDA ratio of about 5.6x. Hence, a business combination would only risk derailing WBD's deleveraging target of under 3x net debt to EBITDA by the end of 2024. Their similar debt maturity profiles could also increase exposure to elevated debt servicing costs, and potential liquidity risks, in the event of a higher for longer restrictive policy stance.
Even if impending rate cuts do materialize in the latter half of next year and the cost of capital comes down, it could potentially coincide with recessionary headwinds. While consumers have been resilient through the past two years of aggressive monetary policy tightening, signs of a cooling labor market could herald weakness and ensuing economic contraction - and rather quickly, too.
This coincides with rapidly deteriorating discretionary spending power at the consumer level as well. Recent data shows that 80% of Americans now have less cash savings on hand than they did before the pandemic. And the most affluent 20% are now only about 8% better off than pre-pandemic levels after adjusting for inflation. The data brings caution to real weakness in consumer spending power ahead, which could harbinger a recession when paired with an accelerated cooldown in the labor market. This would accordingly bring about incremental challenges to WBD's business outlook given its material exposure to consumer end-markets.
Elevated Exposure to Linear TV Headwinds
The thinking behind WBD's potential acquisition of Paramount is likely to enhance its market share within the increasingly competitive media and entertainment business. Specifically, another blockbuster merger would bolster WBD's content library and IP assets. This would likely reinforce WBD's competitive advantage in DTC streaming, and improve its wallet share of consumer discretionary spending. Meanwhile, the company could also be eyeing similar cost synergies like the ones it had planned to (though has yet to) realize on the Warner Media and Discovery merger in 2022.
The first thing that comes to mind is potential regulatory scrutiny, given similarities to both WBD and Paramount's business models. In order to dodge antitrust concerns, the proposed thesis to WBD's potential acquisition of Paramount is that it does not have its own broadcast network like CBS. This means if a potential merger does occur, chances are Paramount's declining TV Media business would be a part of the deal. And WBD really does not need that incremental exposure to a dying linear TV industry.
Specifically, the integration of incremental linear TV exposure would effectively backtrack some of WBD's efforts in striking a balance between network segment declines and DTC growth amid an irreversible cord-cutting trend. As mentioned in the earlier section, WBD's DTC segment has only recently achieved EBITDA breakeven. But it is not yet out of the woods, given ongoing churn dynamics from WBD's restructured streaming strategy, and a tepid long-term subscription growth outlook for the industry. For now, much of the DTC segment's margin improvements have come from cost reduction efforts and post-spinoff cost synergies. The segment has yet to achieve substantial operating leverage improvement with growth at scale, which would be critical to sustained margin expansion.
At the same time, the volume of cord-cutters has grown at an accelerating pace. Specifically, 35% of connected American households have dropped their pay TV subscriptions in favor of on-demand streaming during Q3 - and this number has not stopped expanding since 2017. A similar trend is also spreading overseas, particularly in Europe and emerging markets where WBD and Paramount have historically competed for linear TV market share.
This highlights the growing headache of managing declines in their most profitable linear TV businesses that are now effectively outpacing expansion at their highest growth DTC businesses. Engagement is the core driver of media profitability, and it is what the industry's most coveted advertising business depends on. Without engagement, traditional linear TV networks and broadcast operators like WBD and Paramount lose pricing power and are eventually left with the cost burden of running the capital-intensive business. Paired with the substantial deleveraging required at WBD to improve its balance sheet's flexibility, the company is essentially already walking on a tightrope.
And a potential merger with Paramount would only worsen the situation. Specifically, Paramount's TV Media revenues dropped 7% y/y in the third quarter, a similar pace accelerating declines as WBD's network revenues. Meanwhile, Paramount's relatively smaller share of the DTC streaming market has also struggled to achieve breakeven on an adjusted OIBDA basis.
Admittedly, Paramount has some highly coveted sports broadcasting and streaming rights. These include the Big 10, March Madness, PGA, UEFA, and NFL, which could be accretive to WBD's current portfolio as expands live sports streaming through Max. However, given the seasonal nature of sports-related subscriptions, Paramount's streaming rights to certain franchises are unlikely a sufficient reason for the potential merger.
The Bottom Line
Although the potential merger is still in preliminary discussions and far from materializing, the thought of WBD being open to another capital-intensive undertaking is adverse to the stock's performance. The fact that Warner Bros. Discovery, Inc. is considering a merger with a peer that exhibits a similar, or worse, profile of execution risks is concerning. In our view, we believe such an endeavor would be an irresponsible use of investors' money and adverse to creating shareholder value. It simply is not prudent for management to take investors' money and engage in further M&A activity when it has yet to demonstrate company-specific value proposition against competitors following the capital-intensive, debt-ladened spinoff.
The situation once again weakens confidence in WBD management in our opinion. Any M&A activity would also suggest that the sustained pace of ROIC expansion needed to unlock incremental value in the WBD stock could become further out of reach. If having both the diverse content libraries and iconic franchises of Discovery and Warner Bros. has yet to drive differentiation for WBD in the competitive media and entertainment business, then adding Paramount right now is unlikely to make a big difference. Instead, we favor additional partnerships like the one WBD has recently inked with A24. It entails a lower investment outlay for expanding its content slate needed for furthering engagement.
Looking ahead, investors are likely to remain focused on whether WBD can consistently deliver progress on cash flow growth, deleveraging, and DTC margin improvements. But as the stock fast approaches our price target of $12 , while recent developments underscore the resurgence of elevated execution risks ahead for WBD, we foresee further selling into impending rallies.
For further details see:
Why Warner Bros. Discovery Is Down 6% On Paramount Acquisition Talks (Downgrade)